Should You Be a Sole Trader or a Limited Company?

Should You Be a Sole Trader or a Limited Company?

When setting up a business, there are a lot of major decisions to be made; what will you call yourself; where will you be based; how will you make sure you reach the right customers? One of the more difficult, and one that can have a major impact on your success, is the structure and legal status of your business.

Deciding whether to set up as a sole trader or a limited company can affect everything from the tax you pay, and your financial liability should the business go bust to the legal and reporting requirements you face. There is no one-size-fits-all here, so it’s important to be clear about the advantages and disadvantages of each and how they relate to your individual circumstances.

What is a sole trader?

If you set up as a sole trader, you run your own business as an individual and are self-employed. It’s the simplest business formation available – you can trade under your own name or choose another name for your business. You do not need to register that name with Companies House. You do, however, need to register for self assessment and file a tax return each year. You must also register for VAT if your turnover is over £85,000, or you can register voluntarily if it suits your business, for example, if you sell to other VAT-registered businesses and want to reclaim the VAT.

In terms of ongoing responsibilities, it’s a case of keeping records of your sales and expenses, submitting self-assessments and paying Income Tax and National Insurance Contributions.

What is a limited company?

By registering your business as a limited company, you create an independent entity that is legally separate from the people who run it. This means that rather than taking the profits as wages, as you would as a sole trader, they belong to the company, and you take a salary and/or dividend.

Setting up a limited company is more complex than becoming a sole trader. Firstly, you have to choose a name that hasn’t already been registered with Companies House. Remember, once you register this with Companies House, it is protected by law, and no one else can use the same name as you.

You then need to appoint at least one director who will be charged with meeting the responsibilities that come with setting up a limited company. This includes keeping accounts, informing Companies House of any changes to your registered office address, filing your company tax return, paying corporation tax and more. Even if you hire other entities, such as accountants, to manage these things on a day-to-day basis, as a director, you’re still legally responsible for your company’s records, accounts and performance.

Unsurprisingly there are a number of forms that need to be completed when establishing a new company. This includes an IN01 form, a memorandum of association and articles of association. Together these confirm key information, such as the company’s name, registered office, nature of business, and written rules about running the company. Once these have been submitted to Companies House, you’ll get a Certificate of Incorporation, which confirms that the company legally exists and shows the company number and date of formation. 

Limited company: advantages and disadvantages

While this may seem like a lot of responsibility, especially for those just starting out in business, choosing to operate as a limited company offers a number of advantages.

Perhaps the biggest advantage is the concept of limited liability, whereby if the business should fail, your personal assets are safe due to the legal distinction between you and the company. 

Limited companies also tend to be more tax-efficient than sole traders. Rather than paying Income Tax, limited companies in the UK currently pay Corporation Tax of 19% on their profits, plus there’s a wide range of allowances and tax-deductible costs that a limited company can claim against its profits. 

As you have the option of being a shareholder within your limited company, you are also entitled to dividends, £2,000 of which can be tax free. This opens up the option of taking a small salary and drawing most of your income in the form of dividends, which helps to minimise the amount of National Insurance Contributions you have to pay. This is because dividends are not subject to NICs.

On the downside, operating as a limited company will mean more paperwork and administrative costs, as you’ll need to fulfil the requirements of being a company director, including filing an annual return and annual accounts. You may benefit from bringing in external resources to help with this. 

Sole trader: advantages and disadvantages

Operating as a sole trader brings clear advantages in terms of paperwork and admin overhead – completing an annual self-assessment is the biggest requirement. You can also maintain more privacy as you don’t have to register with Companies House, so your information isn’t available to be viewed and searched online. 

Crucially, though, sole traders do not have limited liability so, if the business gets into debt, you are personally liable as the business owner, and you could lose personal assets.

In the longer term, raising finance can be more difficult as a sole trader, with many lenders preferring to invest in limited companies. In addition, sole traders can face a greater tax burden and, when you reach a certain level of earnings, it can become an inefficient way to run your business as you’ll have to pay tax on all profits that are above the personal tax allowance of £12,750.

Deciding whether to operate as a sole trader or a limited company can be tricky. Both offer advantages and disadvantages, and the right choice for you can depend on everything from the industry you’re operating in and the stage of your business to your capacity to meet essential reporting regulations.

Setting up as a sole trader can seem like the quickest and easiest option and, with around 3.5 million sole traders in the UK, it’s clearly a setup that works for many. But consider your expected profits, future plans, your need for investment and your own finances, as a limited company can offer more security here, particularly with its limited liability status.

Also, remember that the decision you make now can be changed and you can choose to convert to a limited company – or vice versa – as your circumstances evolve.

If you would like the security of being employed at the same time as starting a freelance career read our blog on how to be employed and self-employed at the same time.

Finally, speak to your tax adviser and accountant, as they will have the knowledge and experience to address any queries or concerns you may have and ensure that you make the right choice for your unique circumstances.

Further Reading

2024 Spring Budget: What does it mean for small businesses?

A Guide to Sick Pay for the Self-employed or Company Directors

How to Build Your Accountancy Team